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Deeply and Persistently Conflicted: Credit Rating Agencies in the Current Regulatory Environment

Credit rating agencies have a pervasive and potentially devastating influence on the financial well-being of the public. Yet, despite the recent passage of the Credit Rating Agency Reform Act, credit rating agencies enjoy a relative lack of regulatory oversight. One explanation for this lack of oversight has been the appeal of a self-regulating approach to credit rating agencies that claim to rely deeply on their reputational standing within the financial world. There are strong arguments for doubting this approach, including the conflicting self-interest of credit rating agencies whose profits are gained or lost depending on their ability to lure the business of issuers who will always be seeking the highest rating possible. In recent months, government and press investigations initiated largely in response to the economic turmoil surrounding subprime mortgages have led to additional skepticism about the self-regulating abilities of credit rating agencies' reputational integrity concerns.

This Article argues that the current underlying theories of credit rating regulation may be prone to fail because they leave in place the fundamental conflicts of interest that have been shown to induce profit-seeking credit rating agencies to over-rate securities, indicating to investors a lower amount of default risk than actually exists. If investors were able to fully discount or adjust for this misinformation, a goal of the disclosure requirements of the Credit Rating Agency Reform Act, additional governance may not be required. Unfortunately, there is considerable empirical and anecdotal evidence in business as well as behavioral finance literatures that many investors using credit rating agency ratings are simply not able to perform such adjustments.

This Article develops a governance framework that accounts for the rating agencies' conflicts of interest problem and makes the proposal that public funding augment the current system of evaluating creditworthiness, either through the establishment of a publicly-funded independent credit rating institution, through the hiring of private rating agencies by the government to rate certain securities, or through the use of the tax system to incentivize private rating agencies to issue more accurate ratings. This Article argues that such mechanisms could provide valuable information to investors, could illuminate the reputational compromises credit rating agencies often make in favor of profit-seeking, and, thus, could mitigate a significant amount of the errant information currently produced by private-sector credit rating agencies.